Thursday, July 31, 2008

Readers in Europe may not be aware of the American phenomenon known as the "fantasy camp." This is a primarily (though not exclusively) sporting phenomenon wherein members of the public (usually middle-aged men) pay a not-insubstantial sum of money to spend several days playing with old and retired professionals, many of whom are nonetheless younger than the customers.

The camps are sold as offering a taste of "big league experience", though unsurprisingly the quality of play is anything but big league, as this photo from the Chicago White Sox fantasy camp suggests.

Macro Man is pleased to offer readers a bit of a "macro trading fantasy camp", which aims to give them a taste of what it's like in the market crucible (while carrying the added benefit of being free of charge and not requiring you to dress up in an unfeasibly tight-fitting suit in public.) The incident described below actually occurred yesterday, though some of the key particulars are hypothetical. Enjoy!

THE BACKDROP

You are running a macro portfolio for Fantasy Capital Management LLC, a diversified multi-strategy hedge fund. You started the year well, making money on short equities and short USD/JPY. From mid-March through the end of May, however, you endured a torrid time; equities and USD/JPY squeezed, and your attempts to play incipient rate cut cycles in Europe went disastrously wrong, leaving you flat on the year.

Fortunately, you had a nice June hopping on the short equity train, and you even had the foresight to get out early this month in the vague neighbourhood of the lows. This has left you up 4% year-to-date. It's better than cash, but you're going to need to do better than that if you want to outbid the kleptocrats for that chalet in Courchevel you've got your eye on.

THE TRADE

Being a clever person, you've observed that FX carry is en fuego. Given that equities still seem squeezy, you've decided to put the pedal to the metal and take a large position in the best carry pair in town: short USD/TRY.

There's one small problem, however. The ruling party in Turkey, the AKP, has overseen an unprecedented period of growth and stability in Turkey, and even helped kick-start the arduous EU application process. Unfortunately, they also have ties to the conservative religious community, which is a no-no to the fiercely secular armed forces and constitution.

It's such a no-no, in fact, that a lawsuit has been filed to outlaw the AKP and to ban Prime Minister Erdogan from public life. It's possible that the AKP could be banned, but Erdogan still permitted to hold public office. This wouldn't be too bad, as the members of the ruling party could simply regroup under a different banner.

The case is being heard by Turkey's Constitutional Court. You have done a scenario analysis , and come up with the following:

1) AKP and Erdogan survive. In this case, you'd expect USD/TRY to fall 2% on the day and 7% within a month. Call the agent immobilier and tell him you'll be on the Netjet to pick up the keys to your new chalet in a month's time.

2) AKP is banned, but Erdogan survives. In this case, you'd expect choppy price action on the day, with an unchanged USD/TRY by year end. You'll make a few bucks, but you'll be renting when you ski next February.

3) AKP and Erdogan are banned. This means that the Turkish government is, in effect, declared illegal, leaving a political vacuum that could potentially be filled by the military. You believe that at best you lose 4% if you get out immediately; if you hold the position until year end, you'll lose 10% on it- even including the carry. In this case, you'll be using the student travel agency to book your ski trip.......in Scotland.

THE PHONE CALL

Around lunchtime yesterday , rumours start to swirl that the Constitutional Court has invited milling journalists inside the building. The implication, of course, is that an announcement is imminent. While trying not to talk your own book, this seems bullish to you, as an announcement was not really expected until Friday. Given that an AKP ban would then require individual assessment on the future of all 71 AKP parliamentarians, an early announcement would appear to imply an acquittal. You sell more USD/TRY.

However, the afternoon drags on with no news but plenty of rumour. Finally, at 4.10, your phone rings. You glance at the Turkish newswire that you've been reading all afternoon, but nothing's come up...not even in Turkish.

You pick up the phone, and the first thing you hear is "The AKP's been banned! We're hearing it out of Istanbul! AKP's history! You look at your intraday USD/TRY chart, and this is what you see:

Your Bloomberg "NI Turkey" newswire still has nothing on it, but spot is moving higher. You ask about Erdogan, but the bank has heard nothing, and spot is still going up. You know that if the worst comes to pass, you'll need to act quickly to makes the (enormous) loss as small as possible. You ask for a price, and you get shown a 1.1950 offer in $10 mio, a drop in the bucket. Your heart is pounding, and you know the next 3 minutes will make or break your month, and possibly your year.

SO WHAT DO YOU DO? Do you start buying your position back- you see that at another bank, someone else is already paying 1.20- or do you sit tight?

Welcome to macro fantasy camp, as this is exactly the sort of position that traders find themselves in with alarming frequency. Make your choice, then scroll down to see the outcome.

THE OUTCOME

Spot jumps around for a minute (though it seems like an hour), than your Bloomberg streaming media starts broadcasting the announcement live. In Turkish.

USD/TRY starts drifting lower, but there's still nothing on the newswires. To add a bit of spice to the equation, your daily P/L mark occurs in 1 minute: you have no idea if this will be a great day, a horrible one, or something in between.

Then it comes. A fiery red Bloomberg headline appears on your newswire:

TURKISH COURT REFUSES TO BAN RULING PARTY

"YEAH, BABY!", you shout, no doubt deafening your poor salesperson on the phone. You hang up and high five the guy next to you, thankful that you didn't panic and pay up to cover when spot jumped.

While this little bit of role-playing is fantasy, there is more than a kernel of real-world truth in it. If you do this job long enough, you get to experience plenty of make-or-break flashpoints over which you have no control.

In this case, not paying up was the right thing to do, though had the AKP and Erdogan been banned, you'd be kicking yourself. However, insofar as there's a moral to this little story, it's that it's generally better to make a later, informed decision than an earlier, uninformed one.

As I said, not all the particulars are real-world; while I had an interest in Turkey, the fantasy backdrop was a tad sensationalized- as, alas, is the reward; I am renting next February wherever I go skiing!

Oh man, that made me sweat just reading it. Really! Makes my anxieties about being long the dow when the market got the short financials crack pipe out again at the end of last week feel much more managable.

I was in that exact same position yday and so I assimilate with that experience.

I have been short USDTRY for the past month as my models indicated me to do so. But yday was quite tricky as you had this idiosyncratic risk in the country.

I saw it get paid to 1.2130 (when it was trading at 1.1780 a minute ago!)....and i actually did the mistake of making the uninformed quick decision to cover a quarter of my position.

However even though your note made me realise that yes I should have waited until I had more information in front me, at the same time I did not want to give back all my gains in the past month and thus my intuition told me to book at least some of the profits made. And if I didn't and USDTRY exploded higher I would be kicking myself.

Net net i think the moral is correct in saying that you should be waiting for you to have all the information in front of you. But as a trader you rarely have that luxury, and it's your job to make decisions that maximise potential gains given the constraint of the limited information you have.

At any rate, hindsight is a beautiful thing.

By the way I see USDTRY going to 1.12 and rates continiuing their move lower (positioning in the latter if very clean). At which time the debate will shift to how overvalued the ccy is and how it only a matter of time before the CB comes in and intervenes....

Let me stress again, chaps: this is not a true-to-life first person account. While I did indeed have a Turkey exposure, and I did indeed receive that very phone call, I would never put all my eggs in one basket, particularly one with such a strong circumstance beyond my control. My style is much more to build a portfolio of bets rather make a one-off huge bet.

In fact, my TRY exposure has come via a lottery ticket that is starting to look like paying off, so my risk:reward ratio on this event was much better than I wrote.

Moreover, I had indeed hedged earlier in the day with some cheap short dated TRY puts...so it was never really a question of needing to hedge a massive gasp risk.

All that having been said, there are punters who concentrate lots of their risk in large bets, and who face situations like this. Given that everyone at baseball fantasy camp dreams of playing in the World Series, rather than a meaningless August game between last-place teams, I too some artistic license to increase the suspense of the event.

Well, the mistake, as you point out, is having too much in one position. Given the risk associated with a country like Turkey, I'd have it positioned small, and stay to my conviction until I was proven wrong. Risk/money management is so important.

One of my favourite trading precepts is the best time to hedge is when it seems like you least need it.

Yesterday morning, I bought some Monday 20 delta USD/TRY calls (strike 1.2150) precisely so I wouldn't have to make that tricky decision.

The purpose of the post was to illustrate what's it like to sit in the seat, not to trumpet how clever I am, so I didn't mention the hedge in the text. But I'd certainly argue that the information was out there to enable you to put yourself in the position where you had a positively-skewed risk/reward with no need to panic about gap risk. And that has very little to do with hindsight or luck!

Msg to Macro Man: Prior to your joining your new employment, your blogs were more factual, regarding actual positions, themes and with your positions to view. I believe this blog, now has sufficient professional traders who actually like reading those points to then debate about real positions/themes. Then why throw in fantasy situations, and what if situations, to allow simuations to allow people to see how the seat feels? That is probably not for this audience. My two cents, and my vote for you to write nothing when there is nothing to say other than about positions/themes/changes etc.

First, while today's post was sensationalized, I did have something riding on the announcement...say a potential swing 1.5% of portfolio P/L depending on the outcome. Not a year breaker or maker, but enough to turn a good month into either a great one or an OK one. That's enough to get the adrenaline pumping for me at least, and there are plenty of professional readers in other disciplines who probably had no inkling of yesterday's announcement, or the rumour mongering that goes on in the macro space. (Where's the FSA whingeing about rumour mongering in FX, for example?)

There is also a reasonable cohort on non-professionals, academics, and even policymakers who visit this space, and who benefit from the 'fantasy camp' aspect.

Finally, as there were other people in the trade, and it's not something that often gets a lot of press, I thought it would be interesting to highlight it.

And bear in mind that I often think of new ideas/angles/trades as I write, which is why I try and maintain the discipline of doing it every day.

I was about to make the opposite bet, after reading an interesting research paper on Turkish political turmoil on July, 1st, 2008. Back then, EUR/TRY was a few pips under 1.97 mark. Good thing I decided to sit quietly and wait for a better set up to go long, since today low at 1.80 seems far better (courtesy of Monsieur De La Palisse).

Let’s try with another piece of fantasy macro trading: an obscure US government agency, called BEA, tells you that 4Q 2007 real GDP was “…oops, not +0.6% but rather -0.2%...”. What would you do if they now were to tell you that 2Q 2008 real GDP is +1.9% thanks to a healthy growth in personal consumption expenditures?

Stocks go down, EUR/TRY goes up a little. Stocks go up, EUR/TRY goes down a lot. The position costs 0.30% per week to carry, which gets bloody expensive after a month or two. No fun at all, which is why I unhedged....and saw my lottery ticket blossom into quite a big position.

main assumptions are both fundamental (cumulated trade deficit at almost 8% of GDP, TCMB’s recently upward revision of its own inflation target – not properly good for its credibility, despite it hiking 50 bps recently – and a bet on rising risk aversion in the coming weeks…) and technical (1.80 area served pretty well as a resistance level 2H 2007 and 1Q 2008…). I’m not planning to go outright long on the pair, rather writing far OTM put options (and the negative carry should therefore translate in a higher premium cashed up front…). I’ll wait and see – being an (absolute beginner and paper) trader does have its pros!

MM, I've appreciated instead your post, but i acknowledge that only who does our job (managing money in reality) can understand it.. however good translation!1,5% trade on p/l?? real good one size for a bet!!! but after this glorious moment, come back to reality: long SP500/short russel, after a good rebound yesterday, seems to countinue in an inexhaustible trend. What makes me worried is that it seems to exhibit no correlation to crack trade, crude, fx or i can't find it.. Any guess??

Well, it's the sort of thing where you pay a little bit of premium, and if the TRY goes up a lot u have a chance to make a lot of dough. Along the way, of course, that 'little bit of premo' gets marked on your book at something between 'a little bit of premo' and 'a lot of dough'...which is where I am now!

A highly emotive post MM, certainly chimes with many peoples' experience. The lessons to be learnt encompass both better risk management and emotional discipline, and I think can only be learnt first hand. Its just difficult to hedge well when your product suite is limited! After whipsaw today with US data, tom certainly will be interesting. Cheers, JL

recently, trading the yen has been great via the short yen & long SPX correlation...of course trading the short yen & short SPX correlation has worked too.

is anybody else wrestling with Cramer calling a bottom? if true, it would seem to present some interesting trade opportunities that are not popping up on my radar...so i'm not sure i want him to be right, but i know what everyone else is probably thinking right now...what if he is?

Corey, to be honest I've given up caring about the near-term prospects for equities, and I never actually cared what Cramer had to say except for humour purposes. Whatr I've tried to do is to construct a portfolio that takes equity directionality out of the eqation, and for the time being at least it seems to be working.

Anon, the Turkey trade was put on 3 months ago as a lottery ticket. It increased in value moderately up until thuis week, and yesterday was at the threshold of becoming very interesting indeed, depending on the AKP outcome....hence my interesdt in the matter.

Don't know if you keep up with domestic US news, but Gov Patterson of NY announced a plan to sell state assets (bridges, tunnels, etc) to help address the state's budget crisis. I had two thoughts--- (1) Your tongue in cheek "modest proposal" has become a reality and (2)It may prove difficult to find a buyer for the Brooklyn Bridge now that it may actually be for sale. :-)

Concepts like "Smallcap vs. large cap" are never standing on terra firma where stock indices are concerned.

For a non-specialists, trustees, and even many equity PMs who use it for attribution or benchmarking purposes, still fail to understand the perils in the shifting sands.

For this reason, I would advise NOT using something so imprecise in order to express a thematic view unless you really know what it is actually expressing, and what is dominating returns. Alternatively one can get one's brokers to tailor something more specific, for example small cap retail, bank, services, and restaurant basket versus large cap intl; pharma, ,tech, oil, non-credit fincls (egg STT, NTRS, BK) and consumer non-durables.

For while the sentiment of the trade may be correct, the returns resulting from the expression might (post re-balance) catch you being short way oversold financials and long way overbought energy that migrated in opposite directions as a result of index rebalancing. This is but one example. It's really like playing with fire.

when I got back home yesterday I realized that I completely missed the target on my long EUR/TRY paper trade via writing OTM put options on the pair. I “simply” inverted foreign and domestic interest rates while calculating the forward rate – in other words, I should have thought in Turkish and not in “European”… Well, let’s say I was still enchanted after seeing Lionel Messi playing in Florence the night before: what a player!

Anyway, let’s pretend for a while that you share my view on TRY approaching an interim low vs. EUR: how would you trade that? Via long low delta calls, i.e. your original hedge?

For what it's worth, I think this is one of the best and most useful market blogs around, and would be very sorry if the humour entirely gave way to earnest technical analysis etc. Please keep it the way it is - it's a great source for the UK equivalents of Mrs Watanabe like me....(not that necessarily you would want to encourage any more Watanabes into the game...)

Anon @9.34 , that's hilarious about Paterson. Who knew that this space was being read (albeit in Braille) in such exalter circles?

Cassie, when I did my LC/SC trade, the 2 largest sectors in the RTY were financial services and consumer discretionary. The real pain occurred BEFORE the index rebalance. To be honest, I've got more or less nothing in it now, as no one seems to be able to explain the px action.

AT, it's pretty difficult to come up with a good way of going long EURTRY without being perfect in your timing or spending a large fortune in the process...which is one of the reasons that it is whee it is.

Anon @11.52, that's the trick, isn't it? Structuring a portfolio such that if you are wrong/unlucky/whatever, you lose a little bit, but if you're right, you make a ton of dough. Really, that's the deceptively simple key to long term success in this business:

Don't get killed when you're wrong and make a lot of money when you're right. "A lot of money" means different things to different people, of course; for me, I try and grind out half a percnt a month when my themes aren't working and 3-5% pr month when they are.

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Mr Market wants in just at any price. I am originally from Turkey, now living in Manhattan. At 1.15 to the dollar, Istanbul felt more expensive than Manhattan when I was visiting back in August. In fact a cup of Starbucks coffee cost about 3 dollars in Istanbul while it is 1.65 in Manhattan. With a huge current account deficit, large amount of private sector debt in foreign currencies, and a hugely overvalued currency, all that time I was wondering who would be buying Lira and selling dollars at that rate. Now I know.